Variance Analysis and its Role in Performance Evaluation

Variance analysis is an essential tool in assessing organizational performance against a budget. It helps identify deviations, or variances, from planned results. These deviations are categorized based on their nature, direction, and financial impact.
Core Concepts of Variance Analysis
1. Budget and Variance Relationship: 
Variances are the differences between budgeted amounts and actual outcomes.
On the cost side, a favorable variance occurs when actual costs are below standard costs, whereas an unfavorable variance happens when actual costs exceed standard costs.
On the revenue side, a favorable variance arises when actual revenues exceed budgeted revenues, and an unfavorable variance occurs when revenues fall short.
Impact on Income:
▪️Favorable variances increase income, while unfavorable variances decrease income.
▪️Persistent variances may suggest that the standards or assumptions in the budget need reevaluation.

2. Assignment of Responsibility
Purpose: Assign variances to individuals or departments best equipped to analyze and address the deviations.
Key Points:
▪️Performance metrics should align with cost and revenue drivers.
▪️Managers may oversee activities without direct control but may still hold valuable insights for variance resolution.
▪️Variance analysis fosters learning and continuous improvement rather than blame assignment.

3. Actual Results

The actual results reflect the revenues actually earned and the costs actually incurred.

Actual Results = (Actual Quantity x Actual Price) = (AQ x AP)

4. Key Components of Variance Analysis 
AQ - Actual Quantity
Refers to the actual amount of materials or labor used during production.
STQ - Standard Total Quantity
Refers to the total amount of materials or labor that should have been used for the actual output, based on the standards set.
SP - Standard Price
The predetermined cost per unit of material or labor set during budget preparation.
AP - Actual Price
The actual cost incurred per unit of material or labor used.
ATQ - Actual Total Quantity
Refers to the total amount of inputs actually used in production.
SPSM - Standard Price of Standard Mix
The cost of the standard mix of inputs used for production, based on predetermined prices.
SPAM - Standard Price of Actual Mix
The cost of the actual mix of inputs used for production, calculated at standard prices.

5. Static and Flexible Budgeting 
Static Budget: A static budget is prepared before the budget period begins and remains unchanged regardless of actual performance or activity levels. It reflects management's best estimates for revenues, costs, and other metrics based on the expected level of production or sales for the period.
▪️Measures the difference between the static (fixed) budget and actual results.
▪️Provides a broad overview but doesn’t pinpoint causes of variances.
Static Budget = (Standard Quantity x Standard Price) = (SQ x SP)

◽Static Budget Variance:  The difference between the static budget and the actual results for the period. The static budget variance provides useful information, but it does not explain the cause of the variance.
Static Budget Variance = Actual Results - Static Budget = (AQ x AP) - (SQ x SP)

Flexible Budget: To create a flexible budget, standard costs are established as predetermined measures of the cost drivers to enhance productivity and efficiency. Unlike averages of past costs, standard costs are objective estimates based on accounting, engineering, or quality control studies and serve as a benchmark for comparing actual costs. Similar to a "par" in golf, they help evaluate performance. A standard-cost system alerts management to significant deviations from expected costs and enables better control of actual expenses. Flexible budgeting is crucial for effective standard costing, as it accounts for the impact of fixed costs and allows for a meaningful assessment of variances and managerial performance.
◽Flexible Budget Variance: Flexible budget variances result from variations in the efficiency and effectiveness of producing actual output. They are the differences between 
actual results and flexible budget amounts.
Flexible Budget = (Actual quantity x Standard Price) = (AQ x SP)
Flexible Budget Variance = Actual Results - Flexible Budget 
= (AQ x AP) - (AQ x SP) 
= AQ x (AP - SP)

◽Sales-Volume Variance: Reflects differences between static and flexible budgets, highlighting discrepancies in sales forecasts.
Sales-Volume Variance = Flexible Budget - Static Budget 
= (AQ x SP) - (SQ x SP) 
= SP x (AQ - SQ)

◽Direct Materials Variance: The total flexible budget variance for direct materials can be stated as follows: 
Direct materials variance = Flexible budget - Actual results 
= (AQ x SP) - (AQ x AP) 
▪️This total consists of a price variance and a quantity variance: 
Direct materials price variance = Flexible budget - Actual results 
= (AQ x SP) - (AQ x AP) 
= AQ x (AP - SP) 
Direct materials quantity variance = Static budget - Flexible budget 
= (SQ x SP) - (AQ x SP) 
= (SQ - AQ) x SP 
▪️ A favorable materials quantity variance indicates the use of less than the standard quantity of materials. A favorable quantity variance may therefore result from unusual 
efficiency or the production of lower quality products. An unfavorable materials quantity variance is usually caused by waste, shrinkage, or theft.

◽Direct Labor Variance: The total flexible budget variance for direct labor can be stated as follows: 
Direct labor variance = Flexible budget - Actual results 
= (AQ x SP) - (AQ x AP) 
▪️ This total also consists of a price (rate) variance and a quantity (efficiency) variance: 
Direct labor rate variance = Flexible budget - Actual results 
= (AQ x SP) - (AQ x AP) 
= AQ x (AP SP) 
Direct labor efficiency variance = Static budget - Flexible budget 
= (SQ x SP) - (AQ x SP) 
= (SQ - AQ) x SP 
▪️ A favorable labor efficiency variance indicates the use of less than the standard number of labor hours. A favorable variance may therefore result from unusual efficiency or the 
production of lower quality products. An unfavorable labor efficiency variance may be caused by production delays resulting from materials shortages, inferior materials, or 
excessive work breaks.

◽Mix and Yield Variances : The quantity variance for materials and the efficiency variance for labor can be further subdivided into mix and yield variances: 
Mix variance = ATQ x (SPSM - SPAM) 
Yield variance = (STQ - ATQ) x SPSM

◽Factory Overhead Variances:
▪️ A manufacturer's total overhead variance consists of variable and fixed portions. 
▪️ The variable overhead variance consists of 
Variable overhead spending variance AQ x (AP - SP)
Variable overhead efficiency variance SP x (AQ - SQ)
▪️ The fixed overhead variance consists of a spending variance (Actual - Budgeted) and a production-volume 
variance ( Budgeted - Applied). 

◽Sales Variances: Variance analysis evaluates both the selling and production departments, explaining differences between actual and budgeted revenues. Variances occur due to changes in sales volume, selling price, variable costs per unit, or the product mix. Sales variances highlight these differences, offering insights into revenue, variable costs, and contribution margin fluctuations caused by deviations from planned sales results. Unlike manufacturing variances, sales variances focus on factors like selling price, sales volume, and contribution margin per unit. These variances help identify performance drivers and guide management in refining strategies for better financial outcomes.
▪️ If a firm's sales differ from the amount budgeted, the difference could be attributable to either the sales price variance or the sale volume variance. 
▪️ For a single-product firm, the sales price variance is the change in the contribution margin attributable solely to the change in selling price.
▪️ For a single-product firm, the sales volume variance is the change in the contribution margin caused by the difference between the actual and budgeted volume. 
▪️ If a company produces two or more products, the multiproduct sales variances reflect not only the effects of the change.

◽Market Variances: Market Size and Market Share Variances
Market variances provide insights into why actual sales volumes differ from expectations, helping businesses pinpoint whether changes stem from shifts in overall market size or their specific share of that market. These variances are key to evaluating and refining sales strategies.
▪️Market Size Variance: The market size variance explains how deviations in the total market size impact the budgeted contribution margin. A larger or smaller actual market size than anticipated leads to this variance. 

▪️Market Share Variance : The market share variance examines how differences in the company’s actual market share compared to the expected share affect the budgeted contribution margin. 

By understanding these variances, management can identify whether changes in sales performance result from broader market conditions or internal operational factors, enabling better-informed strategic decisions.

Variance Analysis Benefits
1. Facilitates Management by Exception: Focuses attention on significant deviations.
2. Promotes Accountability: Encourages informed decision-making by assigning responsibility.
3. Enhances Decision-Making: Identifies trends and areas requiring corrective action.

Variance analysis is a powerful tool for monitoring financial performance, enabling businesses to pinpoint inefficiencies and take corrective actions. Whether analyzing direct costs, overheads, or sales performance, variance analysis provides actionable insights for decision-making. By integrating static and flexible budgeting, organizations can adapt to changing conditions while maintaining strategic alignment.